Selling my business - Need some help with the financials

[andreint]

Hi guys,

long story shot - I’m in the process of selling 66% of one of my businesses, but due to the lack of upfront thinking, I’m in a tricky situation.

My business partner and I started this gig without any intention of selling the business, but the opportunity presented itself and now I’m kicking myself for not doing this when we were just starting out (14 months ago).

So, for the sake of keeping everything simple:

- Equity split is 85-15 (I get 85%)
- He receives 15% royalty for every transaction

- Business is valued at $1,000,000
- We’re selling 66% of the business to a group of investors and retaining 33% equity of the new company (no rebranding, just a new legal entity).
- We’re giving away all the future revenue/earnings/profits/royalties and will keep 33% of the equity + some incentives.

That said, let’s say that we’ll get $660k for our 66%, and we’ll keep $340k in equity roll over.

- 85%, my cut, would be $561k
- 15%, his cut, would be $99k

but, here’s where everything gets tricky - how to calculate in his royalty?

His thoughts are that we split 85% of the equity in 85/15 manner, and let him keep 100% of his 15% royalty.

This would translate into something like this:

I would get $477k
He’d get $183k

I’m a bit lost because this doesn’t seem fair if we consider the fact that he’s going to cash in on his royalty 100%, while I’ll lose my net cut from the sales (40%) and a pretty large piece of the cake.

Don’t know if this is the right place to ask this - but some help/ideas would be greatly appreciated

Cheers

 

[CCarter]

Your math looks incorrect. If there is 100 pieces of a pie, and you own 85 pieces, and he owns 15 pieces, selling 66 pieces means that he either sold all his 15 pieces and 51 pieces of your shares leaving you with 34 pieces and him with none. That's why shares of a company are represented in stocks instead of percentages. You sell at minimum 1 share not a percentage of a share.

Don't think of it in percentages, think of them in Stock shares and you'll see your problem. You can't split 1 share by 15%. So in your scenario you own 850,000 shares, he owns 150,000 shares and the investment group wants to be obtain 666,666 shares. You have to decide whose shares all that make up of the 666,666 shares to be sold.

Part 2 of the problem: Why in the world does he have an additional 15% royalty on EVERY transaction? It is retarded or you are miscommunicating this. That's the equivalent of saying if you guys make $1 in revenue he immediately gets 15 cents, and THEN you use the remaining to paying your operating costs, salaries, and the remaining profits you will at the end of the year split 85/15. The dude gets paid multiple times? You fucked up. If it was pure profit from that one dollar he would get 15 cents immediately, plus an additional 12.75 cents at the end of the year profit dividend payout (15% of the remaining 85%), making his take home 37.75 cents, and yours 63.25 cents.

That's the scenario if he truly owns 15% of equity as well as gets immediately 15% royalty on EVERY transaction. If his current setup is like that then you fucked up not realizing this and that's why you are doing the math weird.

Give us a scenario in shares of stock, and you'll realize the problem, cause if he is still entitled to exactly 15% royalty on each transaction, that's regardless of the 15% equity - your investors will probably not like that. For every one dollar being made he takes home 15 cents immediately? That doesn't sound right OR poor thinking ahead in your part. Cause if you have costs of 90 cents to make that one dollar, paying him 15 cents immediately would put you in the hole 5 cents EVERY transaction.

Make it simple, do the transaction in shares, your 850,000 and his 150,000 to make up the 1,000,000 shares. Figure out how many shares you will sell and how many shares he will sell to get to the 666,666 shares the investors want to buy. You cannot split a share or percentages of a single share (which it sounds like you are trying to do). When you sell a company you sell shares of the equity - royalties would be separate.

I would tell him the royalty can no long move forward in the new scenario since everyone will want clean cut understandings - and either you didn't realize he was making nearly double what you though or he tricked you to some degree since you seem to think something is unfair in his suggested payout.

Regardless equity is completely different than royalties, and should be treated differently - I suggest dissolving it if he wants the transaction to have smooth sailing with your new business partners - (FYI he may no longer be a partner if he sells his full 150,000 shares).

Also there is the scenario where he keeps his 150,000 shares, you sell 666,666 shares, and remain with 183,334 shares, and he makes no money from the transaction, but then you have to explain his 15% royalty on every transaction to your new bosses. Either way have your ducks in a row before you present this to your new investors so you two don't look incompetent.

 

[builder]

"His thoughts are that we split 85% of the equity in 85/15 manner, and let him keep 100% of his 15% royalty."

Did you mean to say ""His thoughts are that we split 85% of the equity in 85/15 manner, and also let him have 15% [calculated according to your description] in consideration of his 15% royalty"?

Royalty is for transactions.
According to what you described, you are effectively paying him an additional $84K instead of his 15% royalty.
So that is equivalent to assuming that you will have transactions worth $560,000 (15% of which is $84K).

If you didn't sell it, did you expect that kind of volume in the next 12/24/36/60 years (whether it is 12, 24, 36, or 60 depends on the multiple of your annual revenue which was assigned to your business during the sale)? Is it a stable business? How long will you be running this together?

Since you are losing 34% of the business to investors, shouldn't the 15% now be around 10% since he original intention was to give him 15% of what both of you got together? So, shouldn't 10% be the royalty figure used to calculate one-time payouts?

While there is no right or wrong answer, answering those questions will help you to come up with a solution.

 

[andreint]

Thanks for the replies @CCarter and @builder

I wrote the OP right after waking up and just realized that I fucked up on a massive scale.

The thing is that we never really anticipated this scenario, hence I failed to set everything up properly from the get-go.

2016 was the first year this business was active, and we almost reached $500k in sales.

Our initial agreement was that he’ll own 15% of the business. We’re leveraging his authority in the niche to increase our trust and credibility. He also has a ton of connections that are crucial to the business.

He’s a great guy and I seriously doubt that he has a hidden agenda here. He’s probably playing on the poor business setup card.

I get the 85% (equity and $ from every transaction). My team handles day-to-day and fulfillment, and I work on growth, expansion, etc.

After $1 gets in:
- he gets 15 cents
- operating costs are 45 cents
- I’m left with 40 cents net

We don’t pay out dividends. The money that I net (40c) is not broken down later. It’s completely mine. Strange business model, but it works. At least I thought so.

So, regarding his 15% royalty. New investors are aware of that, and that’s why he agreed to forfeit his royalty. There will be no more paying out anything other than the operating costs once the new entity is setup.

So, he’s trying to get some instant value for the 15%, and I’m not sure if that’s a valid request if we take into consideration that I’m forfeiting my 40% as well.

Love feeling like a clueless idiot sometimes.

 

[CCarter]

After $1 gets in:
- he gets 15 cents
- operating costs are 45 cents
- I’m left with 40 cents net

Yeah, the setup is kind of screwed up since it's hard costs, but that means you'll be absorbing any new overhead through your operating costs. But now it sounds a lot simpler - a bit. It literally sounds just like royalty and not equity. You guys confused yourselves with this setup IMO. Since there is no end of the year profit dividend payout, it's literally just a JV scenario where you divide up the dollar the second it comes in.

Now learning the individual is more crucial than originally thought, you'll have to figure out the line in the new agreement. Maybe since there is 37% left, due to his royalty and this scenario he gets, FOR EXAMPLE, a nice 10% and you get 27% of the newly formed reorganization, and that makes up for the clusterfuck at the beginning and he still gets a nicer chunk coming in of the profits going forward. It's a huge win for him, a bit of a loss for you in the long run, but that also means you take 85% (or whatever number you comfortably agree upon) of the cash the investors are offering to you.

So in this scenario you can play the "you are simply giving up 5% ownership for your payday, I'm giving up 68% ownership, but you'll be taking a lesser of a hit for this sale in terms of ownership, so you'll still be making money."

You could also do an even split of the 37% remaining, and therefore he'll increase his shares of the company from 15% to 18.5%, and still get a payday for his 15%. His compensation will change from getting an exact 15% off every dollar to getting 18.5% of profits at the end of the year, if you pay out dividends, with his 18.5% ownership.

Run a couple of scenarios past him and do the math with dollar amounts to make sure everyone is comfortable with the payout and work it from there. In the end someone's got to give up something, and if you can structure it like the person giving up something is winning in the long run, then you are golden. But also consider that if this business is dying at some level or has plateaued, you personally would probably want the bigger payday now, and sell him the dream, or if you believe it'll grow substantially you probably want the dream and want to sell him a bigger payday now scenario, with less or no equity in the future.

For me personally if I thought he was very crucial I'd make sure he's happy with the compensation and he's also still involved since it'll make sure the company is a success. But if one of you wants to get out - then take the better payday and be done with it. Don't get too greedy cause it'll leave a bad taste in people's mouths and that can effect future opportunities to work with people you've worked with in the past. Basically you can do whatever you want, just have to brainstorm the optimal scenario.

I'd love to know a follow up on what you all decided to end up doing just for my own edification.

 

[andreint]

Pure gold @CCarter . I'll have to read through the post a couple of times, let everything sink in and get back to my Excel sheet.

The deal should be finalized this week, so I'll definitely post an update once we wrap up the negotiations.

 

[Ryuzaki]

This whole situation would be a lot simpler if you can get him to understand that a B2B liquidation event shouldn't be calculated like a B2C transaction.

He's not entitled to 15% of your equity sale nor an additional 15% of his 15%. It makes zero sense and sounds pretty wormy to be honest. His royalty on this sale is packaged in his equity.

What you could do is negotiate an extra payment on top if it all that looks like his "royalty" in order to buy the final 15% equity from him and get him to exit the business altogether, vastly simplifying things for everyone.

I agree with CCarter though and I'm glad he pointed it out. I'd have also been thinking about percentages instead of solid, indivisible shares. That might be your salvation or at least can keep the deal in the realm of being reasonable.

 

[builder]

This is a much simpler situation than all of us originally thought, and you've got some great advice already.

2016 was the first year this business was active, and we almost reached $500k in sales.
...
We’re leveraging his authority in the niche to increase our trust and credibility. He also has a ton of connections that are crucial to the business.
...
He’s a great guy and I seriously doubt that he has a hidden agenda here. He’s probably playing on the poor business setup card.

You're getting $200k per year because of this guy - who, according to you, is straight forward and has vital industry connections - and it is very difficult to get trusted partners like that. Whatever arrangement you end up doing, do not lose sight of that.

$0.02

 

[miketpowell]

You're just going to have to work out what you feel is fair with your partner. If you didn't assign a specific "buy out" value on the royalty that's just something for you to negotiate with the partner. Without agreeing on that you guys cannot sell. Frankly 85k for a royalty that paid 75k last year alone seems like a pretty good deal for you and I wouldn't ask to many questions if he was OK with that. If I was him I'd be demanding 225k for that royalty and THEN splitting the remaining amount 85/15.

On an unrelated note - make sure you have a serious buyer. I've never once seen a serious buyer that doesn't come through a broker. It's ALWAYS someone that is pumping for information before jumping in to compete on their own, no sales ever happen.

 

[andreint]

What you could do is negotiate an extra payment on top if it all that looks like his "royalty" in order to buy the final 15% equity from him and get him to exit the business altogether, vastly simplifying things for everyone.

I have a couple of different scenarios for the royalty. Will be negotiating pretty hard today, but I really want to keep him on board. If he leaves completely, then there's no incentive for him to continue developing the business. Our projections for this year are 45-60% increase in sales, and I'm sure (?) he'll agree to take a larger percentage of the rollover equity in exchange for the royalty buyout. Need to think this through a bit more.

Whatever arrangement you end up doing, do not lose sight of that.

I completely agree.

On an unrelated note - make sure you have a serious buyer. I've never once seen a serious buyer that doesn't come through a broker. It's ALWAYS someone that is pumping for information before jumping in to compete on their own, no sales ever happen.

Yeah, we have a serious buyer + a couple of niche 'gurus' wanting to pitch in and get a piece of the pie. That'd be awesome because them having some skin in the game would mean a ton for our revenue/sales. We'd be able to leverage their trust, connections, and audience the same way we did with my partner (without the royalty xD) and that'd translate in us 3x'ing the 2016 sales easily.

Hm, now when I think about it - paying the royalty now, and keeping more equity makes a ton of sense.

Thanks for the comments @miketpowell, @Ryuzaki, @builder

 

[andreint]

I'd love to know a follow up on what you all decided to end up doing just for my own edification.

Short update. Received a soft offer basically lowballing us @ 2.5 multiple. We declined and are expecting to receive a formal offer today or tomorrow. We're asking for 2.88 multiple, but will probably settle at 2.7x range if the rest of the terms are solid.

 

[andreint]

Just an update

After a lot of negotiations, we settled at 2.75x and closed the deal on March 1st.

The royalty is completely wiped out and the investors paid it out by giving my partner extra %age in the new entity.

I managed to lock in a sweet deal in which I get a standard dividend + a monthly management compensation on a sliding scale (up to 20% EBITA).

All in all, an awesome deal for everyone involved, and the experience I gathered throughout this process is invaluable.

3 months in '17 and we're at 60% of our total revenue from '16.

Back to the grind Thanks for your help guys.